Scenario: You are considering investing in real estateboth for the short-term cash flows and the potential long-term capital gainsand are evaluating both a commercial lease property (such as a strip shopping center or an office building) and a residential rental property (such as several rental houses or a small apartment complex). It is likely that you will invest in only one of these properties at this time.

The general data regarding these investments is as follows:

Property type	Price	Mortgage	Expected		Estimated
			Rental income	Depreciation expense	resale
			(per year)	(per year)	value
Small office building	$800,000	$448,000	$136,016	$7,692	$912,000
Rental homes	$650,000	$292,500	$91,281	$8,273	$685,100

The first potential investment consists of an office building with ten offices, which has a current market price of $800,000. Of this amount, $200,000 represents the cost of the land, and the balance, $600,000, is attributable to buildings on the property. The second possible investment, which costs $650,000, consists of a tract of land containing three rental houses. $195,000 of the investment's total price is reflects the cost of land, and the remaining $455,000 is associated with structures on the land. For both properties, you believe you can increase the rents 2% per year for each of the next four years, and expect to sell either property at the end that time. You desire a return of 7% on your investments.

Assume that your expected annual operating costsexcluding your annual depreciation expensefor the commercial property will be 35% of your annual rental income. For the residential property, the annual operating costs (excluding depreciation expense) will be 20% of your annual rental income. The interest rates of the mortgages for the commercial and residential lease properties are expected to be 6% and 4%, respectively.

Given your other assumptions, complete the following two tables and then use your computations to answer several questions. Round all amounts to the nearest whole dollar. (Hint: Dont forget that capital gains are taxed at 15% if properties are sold for more than their original purchase price.)

Small office building	Year 1	Year 2	Year 3	Year 4
Annual rental income
Estimated resale value	0	0	0
Less: Annual operating expenses
Less: Annual depreciation expense
Less: Annual interest payments (6%)	26,880	25,536	24,192	22,848
Less: Taxes (25%)
Less: Capital gains tax (15%)	0	0	0
Net profit
Interest factor (7%)	0.9346	0.8734	0.8163	0.7629
PV of Cash flow
Total PV of Cash flows

The net discounted return expected from an investment in the office buildingafter deducting the cost of the investmentis

Now perform a comparable analysis for the residential lease property:

Rental homes	Year 1	Year 2	Year 3	Year 4
Annual rental income	$91,281	$93,107	$94,969	$96,868
Estimated resale value	0	0	0	685,100
Less: Annual operating expenses	18,256	18,621	18,994	19,374
Less: Annual depreciation expense	8,273	8,273	8,273	8,273
Less: Annual interest payments (4%)	11,700	11,115	10,530	9,945
Less: Taxes (25%)	13,263	13,775	14,293	14,819
Less: Capital gains tax (15%)	0	0	0
Net profit
Interest factor (7%)	0.9346	0.8734	0.8163	0.7629
PV of Cash flow
Total PV of Cash flows

The net discounted return expected from an investment in the rental homes tractafter deducting the cost of the investmentis .

Based on the results of your analysis, which of the following statements best reflects your decision regarding the commercial or residential lease opportunities?

a) Based on the numbers alone, you should prefer an investment in the office building since it has a net present value that is greater than that expected from the residential lease property (the rental homes tract).

b) As the rental homes tract has a NPV that is greater than that expected from the office building, it is more financially sound to invest in the residential lease property. Because the office building is expected to generate a negative NPV, you should not consider making this investment.

c) As the office building has a NPV that is greater than that expected from the rental homes tract, it is more financially sound to invest in the commercial lease property. Because the rental homes tract is expected to generate a negative NPV, you should not consider making this investment.

d) Given that the rental homes tract has a NPV that is greater than that expected to be generated by the office building, you should prefer to invest in the residential lease property.

Which of the following is not a tax-deductible expense for investment property?

a) The repayment of principal on a mortgage loan

b) Capital improvements

c) Depreciation

Tax-deductible expenses (reduce, increase, has no effect) an investments taxable income, and (reduce, increase, has no effect) the return on your investment.